Robert Frank and Progressive Taxes

In a debate with Robert Frank, David Friedman has pointed out some huge flaws in Frank's argument for higher taxes on "the rich." I found Friedman's critique devastating. I'll point to one highlight and then point out two criticisms I made in 2007 that, as far as I know, Frank has not responded to.

David Friedman's strongest criticism is in the following exchange. First, Robert Frank:

David also believes that a society in which people were concerned about relative position would oppose policies aimed at reducing poverty. ...

He goes on to suggest that my argument implies that "the rich ought to be in favor of grinding down the poor..." These remarks betray a curiously dark conception of human nature.

Now David Friedman's response:

It was your conception, not mine, whose implications I was pointing out. You are the one who argues that people worse off than I am make me happy (and, in the current version of your argument, materially better off) and people better off than I am make me unhappy (and materially worse off).

In other words, if Robert Frank follows his own logical argument, he is the one with the "dark conception of human nature."

In my critique, I proposed an empirical test of Frank's argument that taxing "the rich" would not hurt the rich because none of the would lose their status relative to each other. Here's my statement of Frank's view:

As a bonus, argues Frank, a government can tax high-income people even more than it currently does without making them worse off. How so? For simplicity, imagine a society in which there are a million people making more than $500,000 a year. Most of us would agree, I think, that those people have high incomes. Imagine that they now pay 30 percent of their income in federal income taxes. Now imagine that the government, following Frank's suggestion, imposes a tax on consumption above some amount per year and, thus, raises tax rates on high-income people so that those million people now pay 40 percent of their income in federal income taxes. Because their relative position with respect to each other would be unchanged, and because they spend so much money on positional goods anyway, they would not care--or so the argument goes. As Frank testified, "Thus, if a consumption tax led wealthy families to buy 5,000-square-foot houses instead [of] 8,000, and Porsche Boxsters instead of Ferraris, no one would really be worse off, and several hundred thousand dollars of resources per family would be freed up for more pressing purposes." The government could then take the extra revenue generated by the higher tax rates and spend it on things that people, including many of those with high incomes, value. Because the added tax has a zero cost to those taxed and the revenues create benefits for at least some members of society, the tax creates net benefits. That is, in a nutshell, Frank's argument for higher taxes on people with high incomes.

And my criticism:

Frank argues that consumption taxes on higher-income people make them no worse off because, as noted, they care about relative income, not absolute income. And, presumably, these people put at least a tiny positive value on the things government would spend the additional revenues on. Is Frank open to testing his assumption? Here's a test. If he's right, a majority of those high-income people, indeed a supermajority, would vote in favor of higher taxes on themselves. Frank should propose a referendum on whether to raise tax rates on high-income people, with only high-income people able to vote. If he is right, such a referendum would pass overwhelmingly. I predict that such a referendum would go down in flaming defeat. If I'm right, then the whole empirical basis of his argument is wrong.

Also, because Friedman focused on Frank's recent article, he didn't note just how dramatically Frank's argument has changed since he wrote Choosing the Right Pond in 1987. I did:

A pillar of Frank's argument is that a large percentage of people care about their relative position. In Choosing the Right Pond, he defends that assumption by pointing to anomalies in the pay structure of various firms, anomalies that he attributes to people caring about relative position. Most of his anomalies have to do with pay structures that, Frank argues, are "flatter" than standard economics would predict. Standard economics states that workers are paid an amount roughly equal to the value of their marginal product--that is, the increment in value that is due to their being in the firm. But, notes Frank, if this were true, one would expect to see great disparities between the salaries of workers who have great differences in productivity. He points to, among other things, the University of Michigan pay scale for economists in 1983-84, where the highest salary was only a little more than double the lowest. He never mentions the fact that the University of Michigan is a government bureaucracy, making it not the best test of the standard economics account of freemarket wages. Nor does he mention that one of the main ways the stars of academic institutions are "paid" is with lower teaching loads and more research funds.

Even more interesting is how the world seems to have changed since Frank began writing about these issues and the contortions he goes through to sustain his argument for higher taxes. When he first began, he argued that relatively flat pay structures are indirect evidence for his view that people care a lot about relative position. But in his May 2007 testimony, Frank noted that the "anti-raiding norms of business have recently begun to unravel" so that, now, pay for top managers can be a huge multiple of pay for bottom managers. In other words, it would seem, many top managers are being paid an amount that approximates their marginal product. You might think that this would cause Frank to reexamine his earlier strongly held views. But he doesn't.

Instead, he comes up with a new argument for progressive consumption taxes. He now argues that too many people are vying for the top jobs because of the higher pay those jobs carry. They are fighting, he argues, over a fixed pie and, in a variant of the famous "tragedy of the commons," he compares the competition for the top jobs to gold prospecting. He testified that "the gold found by a newcomer to a crowded gold field is largely gold that would otherwise have been found by others." Similarly, he argues, "an increase in the number of aspiring hedge fund managers produces much less than a proportional increase in the amount of commissions on managed investments."

But he can't hold on to this argument for even a page. Just four paragraphs later, he testified: "A slightly more talented CEO or hedge fund manager can boost a large organization's annual bottom line by hundreds of millions of dollars or more." Exactly. It does make sense, therefore, for companies to look for small differences in talent because those differences can cause huge increases in profits. The problem with Frank's tragedy of the commons analogy is that there is no commons. The tragedy of the commons occurs when no one owns the resource: thus the word "commons." But those who hire hedgefund managers own their resources, so one would not expect overinvestment in being the manager.

HT to Tyler Cowen.

Comments and Sharing

Actually, the debate with Prof. Frank and the crisis in Greece have overlap.

Let us suppose that the Greek government orders all wages, public and private, slashed by 20%. Lower public wages would reduce gov't spending. Lower private wages would make Greece internationally competitive and stimulate employment from lower labor costs.

Why would there be protests? It is all positional goods. If everyone's wage was 20% lower, relative status wouldn't change and so, Frank would argue, no one would care about the cut.

I wonder how much of the "flatness" in pay is due to government regulation of the labor market. Suppose that Person A was twice as productive in a job as Person B. If Person A was paid twice as much as Person B and Person B found out about it, might Person B file a lawsuit and claim discrimination? Has a company ever successfully used productivity differences to fight off a discrimination lawsuit? Or would this be too hard to do and companies just find it easier to pay the rank-and-file basically the same wage across-the-board?

@David Henderson: "Is Frank open to testing his assumption? Here's a test. If he's right, a majority of those high-income people, indeed a supermajority, would vote in favor of higher taxes on themselves."

Would the flight of the upper-class taxpayers from New York City after the tax hikes there represent a good line of evidence in favor of your position?

@Chris Koresko,
Good one. I think so. Frank might argue back that it's not a good enough test because they're just a sub-group of the rich in the whole country. But I think he puts a lot of weight on the idea that people want to be above those immediately around them and, in that case, this would be a good test.

"Frank should propose a referendum on whether to raise tax rates on high-income people, with only high-income people able to vote. If he is right, such a referendum would pass overwhelmingly. I predict that such a referendum would go down in flaming defeat. If I'm right, then the whole empirical basis of his argument is wrong."

The fact that Obama won a majority of those earning $200,000+ is modest evidence of this (although it's entirely possible that many disagreed with him on taxes but supported him for other reasons).

Still, it's sort of false dichotomy here: goods don't need to be entirely positional for them to have some positional effect. The rich may not be made better off with higher taxes, but they may be made less worse off than would be expected by an absolute value hypothesis.

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